Simplifying Exchange Traded Funds.

Cyclical visualisation of the structure of a Mutual Fund, from Investors through to Fund Managers and Actual Securities.

Index Funds are a branch of mutual funds which are passively managed; rather than individually select stocks based on growth potential, the fund reflects a fixed ‘formula’ based on a specific index, such as the ASX200, which can be interpreted as a benchmark of the Australian stock market influenced by large Australian corporations.

ETFs operate in an identical manner to Index Funds. They are also passively managed, which means they avoid incurred active management costs associated with fund management selections. However, the key difference between the Index funds and ETFs is their trading flexibility. Index funds can only be exchanged once a day, whereas ETF’s operate like a company stock and can be exchanged in the market throughout the trading day.

Whilst ETFs are often tied to a reliably performing index like the S&P 500, at its crux, an ETF is a type of fund that can hold multiple underlying assets, whether this be commodities, fixed income or equities. ETFs can be based upon a variety of company stocks across varying industries or can be isolated to a specific sector. For example; the Invesco QQQ ETF indexes the NASDAQ 100, largely comprised of technology stocks.

Sizes and Types of ETFs

Equity Based ETFs are funds which invest in stock assets. They still dominate the relatively ‘new’ ETF landscape and comprise approximately 78% of the $4.3 trillion in exchange traded product assets. Other asset classes like fixed income (17% of assets) and commodities are also experiencing strong growth, and this is largely replicating the upward trajectory of the ETF investment vehicle as a whole.

Popularity increases are being driven by a widespread shift from actively managed mutual funds to passive investment options. From 2007-2016 alone, more than $425 billion was transferred into passive mutual funds, and more than $730 billion was allocated to ETFs. Simultaneously, $835 billion in assets was cut from actively managed funds. Equity-based ETF growth in particular has also been supported by their ability to counteract market volatility. Notable in the 2008 GFC and at the start of 2020 instead of COVID-19, liquidity in underlying markets deteriorated during the selloff, whilst ETFs continued to trade efficiently. Thus, instead of contributing to large market swings, ETFs have become a source of stability as investors are increasingly using ETFs to rebalance holdings and hedge portfolios to mitigate volatility-related risks.

Additionally, the value proposition of ETFs is improving through the benefits of a specific category of equity ETFs known as ‘smart beta’ or factor exchange-traded funds. In equities explicitly, market capitalisation weighting is typically used to determine how many shares of a company’s stock comprise a fund.

From the equation Market Capitalisation = Current Share Price X Outstanding Shares, it can be predicted that a firm that has a rapidly growing stock price with a high level of stock held by shareholders will possess a higher weighting within that ETF.

Smart Beta ETFs instead use a more ‘micro’ approach, selecting assets that only exhibit specific characteristics such as ‘higher than $X total earnings’ or ‘under-priced’ valuations. These ETFs aim to outperform the market portfolio by deviating from a traditional market capitalisation-based index and are thus blurring the lines between the distinct active and passive investment strategies.

Benefits of ETF's

1. Diversification

ETFs are an easy way to diversify an investment portfolio. Their ability to hold a variety of assets, and often assets from the same class, means a single ETF trade can provide ‘instant’ exposure to a diversified portfolio of securities.

2. Cost Efficiency and Convenience

ETF purchases provide a wider range of securities at a lower price than investing in actively managed funds, which takes a percentage cut irrespective of the fund performance. ETFs are also significantly cheaper than individually purchasing assets which incur expensive brokerage/transaction costs.

Passive management doesn’t necessarily result in lower returns; it simply means that the fund isn’t attempting to outperform the market. This is positive if the long-term performance of key market indexes is assessed. The ASX200 has experienced 144% growth over the past 9 years, and over that same period, the S&P 500 has jumped 298%.

S&P500 Growth Illustration, from its December 1980 to November 2020

3. Flexibility

ETFs provide investors with the flexibility to trade any time during the market hours, in the exact same way they would with stocks. ETF shares also have flexibility in how they are used in market interactions; investors can short ETFs, lend ETFs and buy on a margin.

4. Transparency

Often, it is up to investors to determine whether a purchase is suitable for their investment ambitions – ETFs clearly outline their investment strategies and objectives – to achieve returns in line with their established benchmark. Further, holdings are listed daily instead of quarterly, like active mutual or hedge funds.

5. Liquidity

High liquidity in an investment is important as it translates to better entry and exit positions and lower trading costs. ETFs are highly liquid as they can be easily traded throughout the day, but their liquidity is measured in a different way to conventional shares. ETF liquidity is dependent on two components; the volume of actual ETF units traded in the market, and importantly, the liquidity of the individual securities within the ETF ‘package’.